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The weakness in the U.S. dollar has often been cited as a main reason behind the spike in oil prices this year, but some market observers are getting increasingly worried over the potential harm rising oil could do to the greenback.

Long-term evidence suggests that oil and the Dollar Index have shown a strong negative correlation at about 0.7. In other words, as oil prices rise, the dollar would fall and vice versa. The logic behind this is simple: as oil rises, consumers scale back spending, therefore slowing down the economy and leading to lower interest rates and a depreciating currency.

This inverse relationship didn’t hold in previous oil shocks, said Kathy Lien, chief strategist at DailyFX.com. But, she said, the current problems in the U.S. economy have made the dollar more vulnerable to downside risks.

There were three occasions over the past half century when oil prices spiked abruptly.

In 1973, oil jumped 134% after members of the then OAPEC (OPEC plus Egypt and Syria) announced that they were no longer exporting oil to nations that supported Israel in conflict with Syria and Egypt – a move that effectively shut down exports to the U.S., Western Europe and Japan.

In 1979, the price of crude oil soared 118% between January and December, with many analysts attributing the spike to the Iranian revolution and a gasoline shortage.

In both cases, the trade-weighted U.S. Dollar Index, which measures the greenback against a basket of the world’s major currencies, initially rallied along with oil as the Federal Reserve hiked interest rates to combat inflation, then sold off as growth contracted.

But the dollar behaved differently during the 1990 oil shock. Crude prices jumped 113% between June and October that year as a result of the Gulf War. The dollar, which was already in a downtrend because of Federal Reserve’s monetary easing, saw continued weakness this time as U.S. economic growth slowed.

Lien said the characteristics surrounding the oil price surge this time are more similar to the one in 1990 than those shocks of 1973 and 1979. “Therefore, it is easy to understand why the U.S. dollar has continued to weaken despite growing inflationary pressures,” she said.

The Federal Reserve has been consistently cutting interest and these rate cuts have played a far more dominant role in the price action of the dollar than the rise in oil, Lien said. “The market basically doesn’t believe that the Fed will start raising interest rates - and they have good reason to feel this way because based upon the last three oil shocks, growth in coming quarters should contract.”

Proponents of a strong U.S. dollar, especially those that suffered through the last currency crisis in the mid-1990s, have had to bite their tongues the last several years, as it was the weak buck that helped save the U.S. economy in the aftermath of the Internet bubble’s collapse.

In the current slowdown, a sliding greenback seemed another perfect solution. With corporate America and the government banking on the strength of overseas economies to offset a domestic slowdown, a lower dollar would provide a bigger boost to earnings received from abroad.

An orderly decline can be good, but things have gotten a bit out of hand.

Anytime one market, especially one the size of the $3 trillion global foreign exchange market, gets really, really messy, there will be repercussions. Financial markets are about order — without it, risk levels rise, and it becomes harder to make money as traders’ hands get cuffed by nervous management. It’s tough for one trading desk to look over at another desk going crazy, and not feel a bit anxious.

And the dollar’s drop through the 100 yen mark on Wednesday reminded those that survived that last currency crisis how disorderly things can get.

The biggest worry of a falling dollar is that foreign investors, who own large amounts of U.S.government debt, will take their money home. That would send bonds yields soaring, which in turn increases loan costs for consumers, and the stock market reeling.

Stocks are already teetering. If the bond market goes, especially in an environment when the Fed is trying to lower interest rates to stave off recession, then the U.S. economy is in big trouble.

The bond market still seems OK at the moment, although yields are rising relative to overnight rates. But the economy is already in trouble, and a weak dollar is helping contribute to consumers’ pain by supporting, if not actually causing, the historic surge in commodity prices.

It’s no wonder that President Bush, who on record had always supported America’s so-called strong dollar policy (what he supported behind the curtain seemed totally different), didn’t just say on Wednesday that he backed a strong greenback, he went as far as saying that a weak dollar was bad. He’s not the only one.

Government officials around the world have also stepped up the banter against “excessive” dollar moves. While it’s nothing new for overseas officials to talk down the buck, recent chatter has a bit more of a “coordinated” feel to it, just like how the Federal Reserve worked with other central banks to helped ease the credit crisis.

And didn’t the Fed just increase currency swap lines to a number of other central banks?

Whatever the next move, and whoever makes it, something better be done, and soon. If we wait till Obama, Clinton and McCain start talking about dollar policy, it’ll be too late.

Shortly after the Federal Reserve announced plans to inject primary dealers with $200 billion in cash on Tuesday, shares of the Financial Select Sector SPDR ETF (XLF) spiked as investors hoped the move would add much-needed liquidity to cash-strapped financial institutions. However, when the news had been fully disseminated and cooler heads prevailed, the XLF gains were trimmed as analysts and investors speculated on the more poignant question of the day: What happens in 28 days?

“Essentially, it’s a wash,” Thomson Squawk Box analyst John Forman said. “The move doesn’t really add anything new to the system. What’s going to happen 28 days later when the Fed takes back the Treasury paper? Banks need to redevelop trust with one another for there to be any chance of a long-term solution.”

The Fed, thinking out of the box on Tuesday, tried to develop a new, two-prong weapon in its fight against the credit and liquidity crunch, lending up to $200 billion of Treasury securities to dealers for a term of 28 days. The injection will come in the form of a Term Securities Lending Facility (TSLF) auction, where the dealers will be allowed to pledge other, more illiquid securities as collateral, including federal agency debt, federal agency residential-mortgage-backed securities (MBS), and non-agency “AAA/Aaa”-rated private-label residential MBS.

“The TSLF is intended to promote liquidity in the financing markets for Treasury and other collateral and thus to foster the functioning of financial markets more generally,” the Fed said in its statement.

Increases in its existing swap lines with the European Central Bank and the Swiss National Bank served as the Fed’s second prong. The FOMC extended the term of these swap lines through Sept. 30, 2008, and will now provide dollars in the amounts of up to $30 billion and $6 billion to the ECB and the SNB, respectively.

“This is the more interesting aspect of the package,” Forman said. “With the dollar hitting record lows against the euro and the Swiss franc, this opens the door for a possible currency market manipulation in support of the dollar. That is not to say that the central banks will do this, but it at least opens the possibility for a meaningful intervention, which is something we haven’t seen in a long time.”

At least one analyst speculated that a solution to the credit and liquidity problem would need to be fiscal rather than monetary.

“When it comes to the government deficit, there is the good, the bad, and the ugly. The good stems from cutting taxes, the bad from excess government spending, and the ugly from a recession,” IFR Markets analyst Ed Rombach said. “With the U.S. markets heading into a recession, we need more of the good - a tax cut.”

Either way, investors saw something in the move that sparked hope, as they sent the XLF up to its intraday high of $25.08 within the first 10 minutes of Tuesday’s trading session. The financial sector ETF has since given back 78 cents to change hands at $24.30, up 2.8% in mid-day trading.

Because economists have said the U.S. needs to create about 100,000 jobs each month to keep up with new entrants to the workforce, and payrolls have fallen for the second straight month, then the recession must officially be here. The jobs report says so.

Early Friday, the Labor Department said U.S. employers shed more jobs last month than in any month in almost five years. Payrolls fell by 63,000 in February, and January’s 17,000 decline was revised lower to 22,000.

The latest figures pushed the three-month moving average to a 15,000 decline, the lowest level since July 2003.

“Today’s jobs report is the nail in the recession coffin as the losses in payrolls are not only deepening but also broadening into other sectors,” said CMC Markets Chief Forex Strategist Ashraf Laidi. He added that annual inflation above 4.0% and annual average hourly earnings growth at less than 4.0%, puts real earnings at their lowest in two years.

Bernanke may have already hinted that the U.S. is in a recession when he said today’s conditions are more challenging than in 2001, Laidi said. This downturn will be especially challenging, bearing “an ominous combination of the worst of the last three recessions; namely rising inflation of the early 1980s; surging oil prices and housing recession of 1989-90; and falling equity markets of 2001-02.”

“The 63,000 drop in Feb., and the directional change in the last three months is consistent with recession, though the 4.8% unemployment rate is not,” said Joeff Hall, Thomson Financial managing economist. “I’m discouraged by the lack of job creation, but I believe firms are holding back on hiring because of uncertainty rather than outright economic conditions. That said, the worsening credit crisis is making it tougher for me to cheer about this economy.”

Despite the jobs report, which was distinctly worse than the 25,000 job gain which analysts polled by Thomson’s IFR Markets had expected, stock markets and equity futures rose earlier in the session after the Federal Reserve announced it will raise the amount of liquidity in its TAF auctions to $100 billion to “address heightened liquidity pressures in term funding markets.” Investors took back gains, however, and the Dow Jones Industrial Average lost 146 points by the end of the session.

Laidi predicts that, despite the Fed’s stepping up of liquidity operations, it will be forced to slash benchmark interest rates to 2.00% by end of the second quarter. He sees about a 70% chance of 1.50% Fed funds rate by end of year. The payroll report, he added, is an “indisputable negative for the already damaged dollar especially considering the [European Central Bank's] tacit support for its record-high euro.” Nonetheless, the U.S. dollar index ended 5 cents higher at $73.04.

One question to ask is how could job report estimates have been so wrong. Part of the answer, Laidi said, is related to why most economists never expected rate cuts in 2007, or recession in 2008.